Key Takeaways
- Differences in policy at the Bank of England, ECB, and Federal Reserve are creating opportunities for bond investors.
- Record debt issuance at hyperscalers like Meta and Microsoft could lead to deteriorating credit profiles.
- 60/40 portfolio is still valid for investors, but “fixed-income is not going to protect you in all environments”.
Karen Gilchrist: With interest rates still elevated, central banks recalibrating policy, and governments and businesses issuing record amounts of debt to finance everything from defense to AI, fixed-income has once again returned to the fore. That creates a challenging and compelling environment for bond investors. To discuss the risks and opportunities therein, I’m joined by Kelly Gemmell, head of the fixed-income product specialism team for Europe at Vanguard. Kelly, thank you for joining us.
Let’s dive into the latest interest rate decisions from the likes of the Fed and the Bank of England; holding rates. The ECB, too. What does this tell you about major central banks’ approach to inflation right now?
Kelly Gemmell: I think it’s a great question, firstly. I think inflation has been on everyone’s mind since, obviously, that post-Covid era, we felt a little bit scarred by it. But now is very, very different. And you can see that one shock has had a very different response if you were the Bank of England, the Fed or, indeed, the ECB. So, if I think about inflation dynamics, we realize that the US is a little bit more insulated to that energy shock. Particularly in Europe, it’s also a gas factor. It’s been beautiful weather but that’s really meant a lot of strain on the inflation picture in Europe. But you’ve seen a big divergence between the Bank of England, as you said, staying very much firm, whereas the ECB has been hiking. I would say potentially more of a clinical approach. They did their scenarios. They really mapped it out. It’s very clear for us. We think it’s a transparent approach. They’ve hiked, but they were also in a different situation. They came into the year and we were pretty much expecting a hold. But the Bank of England, the Fed, they were expecting cuts. So even a hold is a tightening in financial conditions.
Karen Gilchrist: You mentioned that divergence. How is that affecting global fixed-income portfolios? And where do you currently see the most compelling value opportunities?
Kelly Gemmell: I think it’s a good story if you’re in an active side and you can be a little bit nimble. And actually that’s what we’ve seen in our portfolios, where any given position that you’ve had on, maybe at the start of the year, because the conditions have changed, we’ve changed our mind. So we’ve actually been dialing down risk a little bit. We’ve seen some opportunities play out and we’re conscious of the supply window in September, so we are maintaining a bit of dry powder ready for that opportunity.
How Hyperscaler Debt is Shaping Credit Markets
Karen Gilchrist: Now let’s talk about corporate debt. We’ve seen some of the hyperscalers—the likes of Meta META, Amazon AMZN, Microsoft MSFT—investing hundreds of billions of dollars and really fundraising through corporate credit markets as well to fund their data centers and so forth. What do you make of this market and the risks and opportunities in it?
Kelly Gemmell: I would first of all speak to size. So we talk a lot about the hyperscalers, I enjoy that personally. I know on the equity markets, obviously it’s a huge, huge theme. But in global fixed-income, the exposure to maybe an Amazon or a Google GOOG is maybe less than 15 basis points. So they’re relatively modest exposure. Now, if I look at those credits in particular, it’s possible that you get a deteriorating credit profile as they issue and issue more debt. Not necessarily. They could make it up with tons of revenue, which of course we hope that plays out. But the market is a little bit cautious; we’re fixed-income, after all. So if you look longer dated [corporate bonds], you’re actually pricing that deterioration in quality. So there is fundamentally potentially some value there. But we’re very mindful of those technical factors. They could still drive spreads a little bit wider, and that could actually have an impact beyond those hyperscalers, as the market digests that volume.
Karen Gilchrist: Looking at government debt, we’ve seen in the likes of Europe, governments issuing huge quantities of debt, and looking to do more so, to fund these kind of reforms around defense and green transition, etc. How do you view the current debt issuance of these governments and the larger fiscal deficits? Do they become an issue for these investors?
Kelly Gemmell: I think fiscal discipline is primary, and you can see that in the UK. We’re all waiting eagerly to see the details of a Burnham government, the spending. It’s been encouraging noises so far, but that is a very, very important dynamic. And I think, directionally, you’ve mentioned a couple of the really important trends, like defense spending etc., so I think commitment to the fiscal discipline is super important. And as we think about the US, it’s also just mindful that debt to GDP could actually stay relatively contained. Because if you’re growing strongly, if there’s abundant inflation, you can actually run a bit of a deficit and still maintain your credit worthiness. I just think we ultimately need to be mindful of how prudent they are in the fiscal policy side.
Has the 60/40 Portfolio Been Vindicated?
Karen Gilchrist: We’ve seen the 60/40 portfolio come under scrutiny over a recent years. How useful is this as a framework for long-term investors, or are there different ways that they should be thinking about the role of fixed-income in their portfolios?
Kelly Gemmell: I think income is primary, and now the yields are very attractive in our view, and that’s a long-term story that should play out. So I think there’s certainly a case for protection, getting paid for protection. But what I would say is fixed-income is not going to protect you in all environments. So if you’re high quality fixed-income, we still expect if you move toward a recessionary market, you’ll see central banks cutting, bonds coming to the rescue. But, of course, if inflation really materially ramps up from here, that will put pressure on fixed-income. So we think it’s a nice place to protect your portfolio, but not in every circumstance. But income should really support it, and as we map out scenarios looking forward, we are actually really encouraged and constructive on the pitch of a fixed-income.
Karen Gilchrist: Nice. And any final picks for opportunities or risks in fixed-income?
Kelly Gemmell: Well I think it’s be selective, ultimately. And have a manager that’s nimble. If the market’s changing, then we have to change our mind.
Karen Gilchrist: Kelly, thank you so much for your time. For Morningstar I’m Karen Gilchrist.
